The United States Court of Appeals for the Second Circuit affirmed a Bankruptcy Court’s exercise of jurisdiction over a post-confirmation contractual dispute between Relativity Media, LLC and Netflix, Inc. as a core proceeding.[1]

The dispute between Relativity and Netflix centered around Netflix’s assertion that it had the right under a licensing agreement, as amended, to stream two of Relativity’s films, Masterminds and The Disappointments Room, before they were scheduled to be released in the theatres. Netflix’s proposed actions would have completely undercut Relativity’s recently confirmed chapter 11 plan of reorganization, the feasibility of which was premised on the significant proceeds that Relativity expected to receive from first theatrically releasing the films and then Netflix distributing them under the licensing agreement.

Finding that Netflix did not have the contractual right to do so, the Bankruptcy Court granted Relativity’s motion under section 1142(b) of the Bankruptcy Code to enforce the plan and enjoined Netflix from streaming the films before they were released in the theaters.[2] Netflix appealed, arguing that the Bankruptcy Court did not have jurisdiction over the post-confirmation dispute. Both the District Court and the Second Circuit affirmed.

Following its decisions in In re U.S. Lines[3] and In re Petrie Retail, Inc.,[4] which found core bankruptcy court jurisdiction over post-confirmation disputes concerning the parties’ rights to the proceeds of major insurance contracts and the interpretation of a lease assigned under a Bankruptcy Court-approved sale order, the Second Circuit reasoned that the dispute between Netflix and Relativity was a core proceeding because of the impact that Netflix’s threatened distribution of the films would have on Relativity’s confirmed plan of reorganization.

As recounted by the Second Circuit, during the confirmation proceedings, Netflix objected to Relativity’s proposed plan of reorganization, questioning whether Relativity could actually theatrically release the films on the schedule proposed in the plan, and arguing that theatrical release of the films before distribution by Netflix was a material requirement to the licensing agreement. Relativity’s confirmed plan of reorganization incorporated Netflix’s understanding of the importance of the film’s being theatrically released before being streamed on Netflix. Testimony from the hearing on Relativity’s motion established that Netflix’s pre-release streaming of the films would have eviscerated the revenue streams anticipated by Relativity’s plan. The Second Circuit thus concluded that Netflix’s change of position would significantly impact the administration of the estate and “undercut the creditor relief provided by the Plan,” thus rendering the dispute a core proceeding over which the Bankruptcy Court properly exercised jurisdiction.[5]

[2]. The Bankruptcy Court also found that the doctrines of judicial estoppel and res judicata barred Netflix from asserting it had the right to stream the unreleased films because of the order confirming Relativity’s plan of reorganization and the related proceedings before the Bankruptcy Court.

[5]. Indeed, the Bankruptcy Court did not believe that Netflix’s change in position was made in good faith. The Bankruptcy Court believed that Netflix had recently negotiated more advantageous licensing agreements and speculated that “Netflix waited until very late in the process to spring this new issue on the Debtors in the hopes that it could gain leverage to force a contract change or maybe even a contract cancellation.” In re Relativity Fashion, LLC, No. 15-11989 (MEW), 2016 WL 3212493, at *12 (Bankr. S.D.N.Y. Jun. 1, 2016).

In a recent decision, the United States Bankruptcy Court for the Southern District of New York found that a relatively small retainer placed in the trust account of the foreign liquidators’ U.S. counsel constituted “property” sufficient to satisfy the requirements of section 109(a) of the Bankruptcy Code in a chapter 15 proceeding.[1] The decision elucidates the parameters of the “property” requirement of section 109, which the Second Circuit has applied even in the chapter 15 context.[2]

In August 2014, B.C.I. Finances Pty Limited, Binqld Finances Pty Limited, E.G.L. Development (Canberra) Pty Limited, and Ligon 268 Pty Limited (the “Debtors”), a group of companies controlled and operated by the Binetter family, were placed into Australian liquidation proceedings after allegations of fraud and tax evasion arose.[3] John Sheahan and Ian Russell Lock were appointed as joint liquidators (the “Liquidators”).[4] Following their appointment, the Liquidators brought suit against the Debtors’ corporate directors, including Andrew and Michael Binetter, in Australia, alleging that the corporate directors had breached their fiduciary duties, and that their breaches caused “significant losses” to the Debtors.[5] The trial judge in Australia ultimately ruled in the Liquidators’ favor, but did not come to a determination on the issue of damages.[6]

In 2017, the Liquidators sought chapter 15 recognition of the Australian liquidation proceedings in order to conduct discovery of Andrew and Michael Binetter, who had moved to New York City during the pendency of the trial in Australia.[7] Andrew Binetter, along with another party (together, the “Objecting Parties”), opposed the Liquidators’ chapter 15 petition.

The Objecting Parties claimed that the Debtors were ineligible for chapter 15 relief because they did not have sufficient “property” in the United States to satisfy section 109(a) of the Bankruptcy Code. Section 109(a) states that “only a person that resides or has a domicile, a place of business, or property in the United States . . . may be a debtor under this title.”[8] The Second Circuit has held that this requirement must also be satisfied in the context of chapter 15 proceedings.[9] However, the Second Circuit did not specify a threshold for the amount of “property” sufficient to satisfy this requirement in the chapter 15 context.

In response, the Liquidators argued that (1) a $1,250 retainer placed in the trust account of the Liquidators’ counsel (the “Retainer”) and (2) the Debtors’ fiduciary duty claims against Andrew and Michael Binetter (the “Fiduciary Duty Claims”) constituted “property in the United States” sufficient for section 109(a) eligibility.[10]

The Bankruptcy Court held that the Retainer and the Fiduciary Duty Claims each independently satisfied the section 109(a) requirement.[11] Before concluding that even a $1,250 retainer may satisfy section 109(a), the Court noted that “it is well established that ‘[a] debtor’s funds held in a retainer account in the possession of counsel to a foreign representative constitute property of the debtor in the United States and satisfy the eligibility requirements of section 109.’”[12] Furthermore, the court emphasized that the “property” requirement in section 109(a) is satisfied even by a “minimal amount of property” in the United States.[13] The court then rejected the Objecting Parties’ argument that the Debtors’ deposit was made in order to “manufacture eligibility under Section 109.”[14]

The court next addressed whether the Fiduciary Duty Claims were located in the United States, since it was undisputed that the Fiduciary Duty Claims were property of the Debtors. Using a multi-step analysis, the court first applied New York’s “greatest interest test,” holding that the situs of the Fiduciary Duty Claims should be determined according to Australian law.[15] Then, after considering expert testimony on the issue, the court determined that, under Australian law, claims “are situated where they are properly recoverable and are properly recoverable where the debtor resides.”[16] Therefore, the court concluded that, because the Binetters lived in New York, the situs of the Fiduciary Duty Claims was New York and qualified as “property in the United States.”

Although the Barnet decision imposed an additional eligibility requirement for foreign representatives seeking chapter 15 protections,[17] the Bankruptcy Courts have consistently lowered the barrier, ensuring that foreign representatives are afforded easy access to the protections offered in chapter 15. With this low barrier, even a de minimis amount of funds deposited in a trust account for the purpose of retaining counsel may satisfy the eligibility requirement. In addition, claims that situated in the United States under applicable laws may also satisfy the requirement.

[17] Barnet, 737 F.3d at 251 (holding that a debtor within a foreign proceeding seeking recognition under chapter 15 must satisfy the section 109(a) requirement of residing or having a domicile, place of business, or property in the United States).

After a 2014 decision in the Southern District of New York holding that section 316(b) of the Trust Indenture Act (“TIA”) barred any non-consensual restructuring that impaired a creditor’s actual ability to receive payment, issuers, creditors and the financial markets more generally have been uncertain as to the contours of permissible out-of-court restructurings.[1] The recent decision by the Second Circuit Court of Appeals in Marblegate Asset Management, LLC v. Education Management Finance Corp., 2017 WL 164318 (2d. Cir 2017) reversed the 2014 ruling and held that section 316(b) only bars restructurings that that impact a creditor’s core payment right, which is different from the practical ability to demand payment. The Second Circuit’s Marblegate ruling will help resolve the disquiet among practitioners and issuers and restore expectations as to the ability of companies to conduct out-of-court restructurings without being hamstrung by non-consenting creditors.

Background of the Marblegate Rulings:

The Second Circuit’s decision arose from the restructuring of the debt of Education Management Corporation (“EDMC”). EDMC is a for-profit higher education company that had: (i) $1.3 billion in secured obligations that were collateralized by virtually all of EDMC’s assets, and (ii) $217 million of unsecured notes (the “Notes”) that were issued by a subsidiary of EDMC and governed by an indenture qualified under the TIA (the “Indenture”). The Notes were guaranteed by EDMC, but the guarantee was basically worthless as it had been issued solely to satisfy EDMC’s reporting obligations and would be automatically released if any secured creditor provided a release of any separate guarantee of EDMC (a fact that was clearly disclosed to potential Noteholders in the offering circular for the Notes).

Cash-strapped EDMC entered into negotiations with its secured creditors that resulted in a restructuring proposal.[2] Under the proposed restructuring, the secured lenders would exercise their rights under their credit agreement and Article 9 of the Uniform Commercial Code to foreclose on all of EDMC’s assets and release EDMC from their guarantee (thereby automatically releasing EDMC from the Note guarantee). The secured lenders’ collateral agent would then transfer all of the foreclosed assets to a newly created subsidiary of EDMC that would then issue new secured debt and stock to the secured lenders and any unsecured lenders that consented to the restructuring. Importantly, the restructuring did not change the actual payment terms of the Indenture or limit the Noteholders’ ability to sue the EDMC subsidiaries that issued the Notes to collect the payment due on the Notes (albeit a futile exercise, because the EMDC subsidiaries would have no assets after the restructuring).

All of EMDC’s creditors, representing 98 percent of the company’s debt, consented to the proposed restructuring. The sole holdout creditor was Marblegate Special Opportunity Master Fund (“Marblegate”), which sued to enjoin the restructuring on the grounds that it violated the TIA.

The District Court Decision

Noting that the TIA itself was ambiguous, the District Court agreed with Marblegate and held that the proposed restructuring violated Section 316(b) of the TIA,[3] which prohibits any restructuring that “impair[s] or affect[s]” the “right” of any security holder to receive payment due under a note.[4] After reviewing the text and legislative history of Section 316(b), the District Court concluded that the TIA “protects the ability” of the Note holders “to receive payment in some circumstances.”[5] Even though the Indenture payment terms remained the same, the District Court held, Section 316(b) is violated whenever a transaction “effect[s] an involuntary debt restructuring.”

EDMC appealed and argued that the prohibition contained in section 316(b) of the TIA applies only to non-consensual amendments to an Indenture’s core payment terms (here the ability of Marblegate to commence suit to demand payment from the EDMC issuers).

The Second Circuit’s Ruling

The issue before the Second Circuit therefore was whether section 316(b)’s prohibition on any restructuring that “impair[s]” or “affect[s]” a “right . . . to receive payment” contained in Section 316(b) of the TIA should be read narrowly to bar only non-consensual amendments to an indenture’s core payment terms, or whether it should be read broadly to prohibit any restructuring that affects the ability of a noteholder to receive payment. After a review of the parties’ competing readings of the statute, the Second Circuit agreed that the text of Section 316(b) was ambiguous on this issue.[6] The court noted that the use of “‘right’ to describe what it sought to protect from non-consensual amendment suggests a concern with the legally enforceable obligation to pay that is contained in the Indenture, not with a creditor’s practical ability to collect on payments.”[7] However, the Court also noted that the section of 316(b) stated that such a right “cannot be ‘impaired or affected,’” and Congress’ inclusion of these terms implied that a creditor’s payment right could not validly be reduced or “otherwise affect[ed] in an injurious manner.”[8]

To resolve these competing interpretations, the Second Circuit analyzed the legislative history of the TIA and ultimately concluded that Congress intended a limited application of the prohibition contained in Section 316(b).[9] Based on its review, the court determined that Congress was well aware of “possible forms of reorganization available to issuers, up to and including foreclosures like the one that occurred in this case” and noted that “foreclosure-based reorganizations were widely used at the time the TIA was drafted.”[10] This fact, combined with the expert testimony submitted to Congress at the time of the TIA’s drafting on the limited purposes of the TIA, demonstrated that Congress intended section 316(b) of the TIA to be applied narrowly to bar revisions to the core payment terms of an indenture but did not intend to prohibit the type of foreclosure-based restructuring employed by EDMC.

In addition, the court noted that the broad reading of section 316(b) put forth by Marblegate and endorsed by the District Court raised a number of practical problems, as it would require courts in every case to divine “whether a challenged transaction constitutes an ‘out-of-court debt restructuring . . . designed to eliminate a non-consenting holder’s ability to receive payment.’”[11] The practical requirement of determining the subjective intent of the parties to the restructuring, as opposed to a review of the transaction itself, ran afoul of the Second Circuit’s “particular distaste for interpreting boilerplate indenture provisions based on the ‘relationship of particular borrowers and lenders’ or the ‘particularized intentions of the parties to an indenture,’ both of which undermine ‘uniformity in interpretation.’”[12]

Conclusion

The Second Circuit’s ruling provides a framework by which companies can achieve out-of-court restructurings even though they might deprive dissenting creditors of the value of their notes. The fact that core payment terms remain unchanged, though, may encourage companies to take a more aggressive stance with creditors. Nevertheless, creditors are not without remedies, as the preservation of core payment terms allows dissenting creditors to pursue judicial remedies. The ability of dissenting creditors to pursue successor liability or fraudulent conveyance claims may operate as a check against restructurings that are not conducted at arms’ length or with improper intentions to deprive certain credit groups of payment.

[4] Section 316(b) of the TIA, entitled “Prohibition of impairment of holder’s right to payment,” provides:

Notwithstanding any other provision of the indenture to be qualified, the right of any holder of any indenture security to receive payment of the principal of and interest on such indenture security, on or after the respective due dates expressed in such indenture security, or to institute suit for the enforcement of any such payment on or after such respective dates, shall not be impaired or affected without the consent of such holder, except as to a postponement of an interest payment consented to as provided in paragraph (2) of subsection (a) of this section, and except that such indenture may contain provisions limiting or denying the right of any such holder to institute any such suit, if and to the extent that the institution or prosecution thereof or the entry of judgment therein would, under applicable law, result in the surrender, impairment, waiver, or loss of the lien of such indenture upon any property subject to such lien.

[6] Judge Straub dissented on this basis and believed that the text of the TIA was clear and unambiguous and supported the District Court’s ruling. Judge Straub noted that if Congress had “intended merely to protect against modification of an indenture’s payment terms, it could have so stated” and that “nothing in the text of the statute requires the narrow reading that Section 316(b) merely prohibits modification of an indenture’s core payment terms (amount and due date) by noteholder majority action without consent of the individual noteholder.” He recognized the practical difficulties and uncertainty that his interpretation of the TIA would cause, but noted that such concerns were insufficient to override what he reasoned was the correct reading of the statute.

[9] Starting in 1936, the Securities and Exchange Commission (SEC) published a comprehensive eight-part report examining the role of protective committees in reorganizations.5 Part VI of that report, published in 1936 and entitled “Trustees Under Indentures” (the “1936 SEC Report”), led to enactment of the TIA. Additionally, the Court reviewed subsequent congressional reports, testimony, and other statements by SEC officials in reaching its decision.

In a recent opinion providing guidance to bankruptcy courts on a developing issue of law, the Second Circuit affirmed a decision of the District Court for the Southern District of New York subordinating contribution claims pursuant to section 510(b) of the Bankruptcy Code because they arose from the purchase or sale of a security of an affiliate of the debtor. In its decision, the Second Circuit expressly recognized the equitable powers of the bankruptcy courts to determine the appropriate level of subordination.

In ANZ Securities, Inc., et al. v. Giddens (In re Lehman Bros. Inc.), the trustee for the liquidation of Lehman Brothers Inc. (LBI) under the Securities Investor Protection Act of 1970 (SIPA) had moved the Bankruptcy Court in 2013 to subordinate claims by various underwriters seeking contribution from LBI as co-underwriter for securities issued by Lehman Brothers Holdings Inc. (LBHI), LBI’s parent. A group of underwriters asserted that approximately $78 million in settlements and legal fees incurred in defending claims by investors in the LBHI securities should be reimbursed by LBI under the underwriting agreements.

In his motion, the trustee relied on section 510(b), which provides that “a claim arising from rescission of a purchase or sale of a security of the debtor or of an affiliate of the debtor, for damages arising from the purchase or sale of such a security, or for reimbursement or contribution allowed under section 502 on account of such a claim, shall be subordinated to all claims or interests that are senior to or equal the claim or interest represented by such security.” 11 U.S.C. § 510(b) (emphasis added). The trustee argued that, under the plain language of the statute, these claims must be subordinated because they sought reimbursement or contribution and arose from the purchase or sale of securities issued by an affiliate of LBI. The underwriters argued that § 510(b) did not apply because the LBHI securities do not represent any claims or interests in the LBI SIPA proceeding.

As we previously covered, on January 30, 2014, the Bankruptcy Court for the Southern District of New York granted LBI’s motion and subordinated the underwriters’ claims to the claims of general unsecured creditors, reasoning that “the claims represented by such security are the claims of the []Underwriters for reimbursement and contribution.” In re Lehman Bros, Inc., 503 B.R. 778, 787 (Bankr. S.D.N.Y. 2014) (Peck, J.). After an appeal, on September 5, 2014, the District Court affirmed the Bankruptcy Court’s Order, but applied a different interpretation of the portion of § 510(b) that governs the level to which the claims must be subordinated. Specifically, the District Court focused on the type of security rather than the type of claim involved, and explained that, “a straightforward and practical application of section 510(b) recognizes that unsecured, non-equity securities represent unsecured claims, meaning that claims involving such securities must be subordinated to general unsecured claims.” In re Lehman Bros. Inc., 519 B.R. 434, 451 (S.D.N.Y. 2014) (Scheindlin, J.).

After further appeal, on December 14, 2015, the Second Circuit affirmed the District Court’s decision and adopted Judge Scheindlin’s construction of § 510(b). The court held that, “in the affiliate securities context, ‘the claim or interest represented by such security’ means a claim or interest of the same type as the affiliate security.” ANZ Securities, Inc. v. Giddens (In re Lehman Bros., Inc.), No. 14-3686, 2015 WL 8593604, at *3 (2d Cir. Dec. 14, 2015) (Jacobs, Walker, Livingston, JJ.). Accordingly, “claims arising from securities of a debtor’s affiliate should be subordinated in the debtor’s bankruptcy proceeding to all claims or interests senior or equal to claims in the bankruptcy proceeding that are of the same type as the underlying securities (generally, secured debt, unsecured debt, common stock, etc.; and in some circumstances potentially a narrower sub‐category).” Id. Relying mainly on textual principles, in addition to legislative history and policy rationales for the statute, the court explained that this construction allowed the statute to apply to claims related to affiliate securities, which were expressly included in the provision. The court rejected the underwriters’ narrow construction which would limit the affiliate securities provision to two hypothetical scenarios (i.e. when the debtor has guaranteed payment of its affiliate’s securities, or when the estates of the debtor and its affiliate are substantively consolidated), citing Second Circuit precedent construing the statute broadly. The court also made clear that the text of § 510(b) applies to claims for contribution or reimbursement.

With its instruction to subordinate claims based on the type of the underlying securities, the Second Circuit explained that bankruptcy courts, as courts of equity, might need to group claims for subordination into narrow sub-categories, or add tiers if priority levels among the affiliate’s securities are not mirrored in the debtor’s estate, but also noted that the bankruptcy courts are well-suited to do so. The court emphasized that “bankruptcy judges regularly make these determinations, and they are better situated to do so” than appellate courts. ANZ Securities, 2015 WL 8593604, at *7. As a practical matter, the court noted that “it may become somewhat messy to superimpose the capital structure of the affiliate onto that of the debtor,” but found that this approach “preserves flexibility needed by the bankruptcy court.” Id., at *6. In the LBI SIPA proceeding, the issue is straightforward because there is no need for the bankruptcy court to make any further determinations once the claims are subordinated below the level of general creditor claims.

Prior to this decision, only a handful of courts had addressed the question of whether and how to subordinate claims based on affiliate securities. Though every such court has found that subordination is required in this situation – at least when the debtor was a corporate entity – these decisions each had varying interpretations of § 510(b). The recent Court of Appeals’ decision in ANZ Securities v. Giddens provides a clear and thorough interpretation of the statute’s affiliate clause that will guide lower courts within the Second Circuit and likely in other jurisdictions as well. The decision makes clear that the text of § 510(b) is to be construed broadly, such that claims arising from the securities of an affiliate of the debtor, including contribution or reimbursement claims by non-investors such as underwriters, must be subordinated. Importantly, the Second Circuit also makes clear that, as a specialized court with equitable powers, the bankruptcy court has the ability to sort out the potentially complex issues involved in determining priority levels for subordination.

On Wednesday, January 14th, 2015, the Second Circuit declined to grant an en banc review of its holding requiring a full Section 363 review of a claims sale in a Chapter 15 proceeding in the case of In Re: Fairfield Sentry Ltd. This decision left intact the Second Circuit’s earlier holding that dramatically expanded the ability of a bankruptcy court in a Chapter 15 proceeding to weigh in on issues related to the disposition of property within the United States and sharply curtailed the required deference to the foreign court in these proceedings.

The underlying dispute centered on the sale of a $230 million claim by the bankruptcy estate of Fairfield Sentry Limited to Baupost Group LLC, a hedge fund. Fairfield was an investment fund that had invested 95% of their assets in the Madoff ponzi scheme that collapsed in 2008, and following the Madoff bankruptcy Fairfield entered into its own liquidation in the British Virgin Islands, which was recognized under Chapter 15 in 2010. Subsequently, Fairfield sold its claims in the Madoff liquidation for approximately 32 cents on the dollar, but three days after the signature of the trade confirmation, the announcement of new recoveries in the Madoff liquidation increased the value of the claim to over 50 cents on the dollar.

Following approval of the sale in the British Virgin Islands over the objections of the Fairfield Trustee, the Bankruptcy Court denied an application for section 363 review on the basis that the SIPA claim was not property within the United States, and that comity dictated deferring to the British Virgin Islands court that had approved the sale. The District Court, on appeal, affirmed the Bankruptcy Court.

The Second Circuit’s initial decision on September 26, 2014 held that the claim in the Madoff proceeding was property within the United States and subject to Chapter 15 review as the claim was subject to attachment or garnishment by US courts, and accordingly under Section 1502(8) constituted property within the jurisdiction of the United States. Furthermore, the Second Circuit held that the Bankruptcy Code clearly required a section 363 review due to the language that stated that section 363 applied in a Chapter 15 proceeding “to the same extent” as a Chapter 7 or Chapter 11 proceeding. Accordingly, the Second Circuit held that the principle of comity remained strongly applicable in Chapter 15 proceedings, it did not override the requirement for an independent section 363 review of the sale.

Furthermore, the Second Circuit noted that the section 363 review must include the significant increase in the value of the claim following the sale rather than merely analyzing the transaction at the moment of the sale. This requirement, given the significant increase in the value of the claim, makes it significantly more difficult for the buyer, Baupost Group, to secure approval of the sale.

Following the original order, Baupost moved for reconsideration en banc or, in the alternative, a an amendment of the decision to preserve Baupost’s alternative arguments that no section 363 hearing was required. Specifically, Baupost argued (i) that section 363 was discretionary rather than mandatory, (ii) that the bankruptcy court, in its recognition of the British Virgin Islands proceeding order, had entrusted to the Fairfield Trustee the “administration or realization of any property located in the United States” making review unnecessary, and (iii) that the sale of the SIPA claim was in the ordinary course of business. The Second Circuit directed the Fairfield Trustee to respond to these three alternative arguments. The response argued that each of these three arguments had been presented to the Bankruptcy Court or the District Court and either explicitly or implicitly rejected. Following this response, the Second Circuit denied Baupost’s motion without further comment.

As a result of this decision, parties should be aware that their transactions with foreign bankruptcy companies will likely be subject to both a standard review in the foreign bankruptcy court, as well as a full section 363 review in the United States. This will likely be most significant in cases where the foreign court’s review will not take into account subsequent developments, while the Second Circuit’s decision requires the US courts to take those developments into account when determining if approval should be granted.

On November 5, 2014, the Second Circuit (Judges Winter, Droney, and Hellerstein) held oral arguments in In re Tribune Litigation (Case No. 13-3992) and Whyte v. Barclays Bank PLC (Case No. 13-2653). As we outlined here, both cases consider the reach of the safe harbor provisions found in section 546 of the Bankruptcy Code that protect certain financial transactions from constructive fraudulent avoidance claims. The District Court dismissed the plaintiffs’ state law constructive fraudulent conveyance claims in both cases, but reached different decisions on the key question of whether the Bankruptcy Code’s safe harbor provisions impliedly preempt state law causes of action brought by creditors. Judge Rakoff held that implied preemption applied in Barclays while Judge Sullivan held that the express language of the safe harbors did not preempt state law claims brought by creditors in Tribune. The defendants in both cases garnered support from numerous amici, including the U.S. Securities and Exchange Commission, U.S. Commodity Futures Trading Commission, the Chicago Mercantile Exchange Inc., the Security Industry and Financial Markets Association, and the International Swaps and Derivatives Association.

At argument, counsel for the creditors’ representative of SemGroup and Tribune both argued that it is clear from the plain language and legislative history of the safe harbor statute that Congress did not intend to preempt state law. In support of this argument, the creditors’ counsel pointed to, among other things, (i) the express limitation in the statute to claims brought by the trustee (rather than creditors), (ii) language in a separate section of the Bankruptcy Code expressly preempting state law causes of action for avoidance of charitable contributions, (iii) the numerous amendments to the safe harbor provisions without the addition of an express preemption clause, and (iv) a 1976 congressional committee report that shows that the committee did not incorporate the U.S. Commodities Futures Trading Commission’s request for an express preemption provision. In response, counsel for the defendants in both cases argued that (i) allowing the state law fraudulent transfer claims to proceed would conflict with Congress’ stated purpose in enacting the safe harbor – to ensure stability of the financial markets, (ii) that the creditor representatives should not be permitted to end run federal law by applying state law; (iii) that the scenarios at issue – non-trustee “creditor representatives” pursuing claims under state law that are barred by section 546 – would occur in every case if not barred here.

The court reserved judgment, but early interpretation of oral argument suggests that the majority of the court was persuaded that the safe harbors impliedly preempted the state law causes of action, with one judge noting that the creditors’ state law claims were “the very evil” that Congress intended to avoid when it passed the safe harbor provisions.

In an April 11, 2014 decision the Second Circuit affirmed a ruling by the Southern District of New York, dismissing claims that certain Refco customers facilitated the wrongdoing of the now bankrupt financial services firm.

In Krys v. Pigott, 749 F.3d 117 (2d Cir. 2014), the plaintiffs were liquidators for a family of hedge funds that were customers of the financial services company Refco. The hedge funds had suffered significant losses in connection with Refco’s now infamous bankruptcy.

The liquidators filed suit against a group of customers of Refco alleging that the customers participated in a number of “round-trip” loan transactions with Refco and thereby aided and abetted Refco’s fraud and breach of fiduciary duty.

Under the “round trip” loan transactions, Refco would “loan” up to $720 million to some of its customers, including the defendants, who would then “loan” the same amount to RGHI, a Refco-related entity whose principal asset was shares of Refco. RGHI would then use the money it borrowed from the customers to pay down debt owed to Refco. By engaging in these circular loans at the end of every reporting and audit period, and then unwinding them by reversing the process after the start of each new reporting or audit period, Refco was able to conceal a large related-party receivable and the company’s overall insolvency.

In reviewing the claims against the customers, the Second Circuit agreed with the District Court ruling that under New York law, claims for aiding and abetting fraud and breach of fiduciary duty required the liquidators to establish that the alleged aider and abettor had actual knowledge of the underlying wrongful conduct.

The court emphasized that “constructive knowledge,” i.e. that the defendants should have known that they were aiding and abetting fraud or breach of fiduciary duty, was not enough to satisfy the scienter requirement for the allegations.

Although the liquidators alleged that the customers “knew and/or consciously avoided knowing” that the “round-trip” loans were created so that Refco could issue fraudulent financial statements and hide its insolvency, they failed to allege sufficient facts to “give rise to any reasonable inference that [the customers] knew or even suspected that Refco was insolvent” or that the loans were designed to hide that fact.

The court was not persuaded by arguments that the timing, specific amounts, or increasing size of the loans should have tipped the customers off about their fraudulent nature, and the court found it implausible that the customers knew about Refco’s insolvency because they continued to do business with the company, at times insisting on having the loans guaranteed by Refco.

In the absence of facts indicating that the customers had actual knowledge that Refco was engaged in fraud or breaching its fiduciary duties, the liquidators had failed to state a claim.

The Second Circuit decision demonstrates that future plaintiffs bringing similar claims will have to plead their cases with greater particularity, alleging facts sufficient to establish actual knowledge by those who they claim aided or abetted fraud or breach of fiduciary duty.

Companies struggling to address liquidity problems are often attracted to debt-for-debt exchanges because such exchanges accomplish many of the same purposes as refinancing without requiring upfront cash payments, except to cover transaction costs and professional fees. By restructuring debt obligations, a financially distressed company may avoid default and escape bankruptcy. Partaking in a debt exchange is advantageous for creditors because, among other things, the new debt is frequently more senior in a company’s capital structure than the existing debt.

To date, however, it has been unclear whether the unamortized interest – i.e. original issue discount (“OID”) – generated by these exchanges would be an allowable claim in bankruptcy. A recent decision of the U.S. Bankruptcy Court for the Southern District of New York answered this question in the affirmative in Official Comm. of Unsecured Creditors v. UMB Bank, N.A. (In Re Residential Capital, LLC), 501 B.R. 549 (Bankr. S.D.N.Y. 2013), finding that original issue discount can serve as the basis of a valid claim.

Face Value Exchange v. Fair Market Value Exchange

There are two types of debt-for-debt exchanges: face value and fair market value. In a face value exchange, a comparatively healthy organization with liquidity problems exchanges old debt for newly issued debt to obtain short-term relief while remaining fully accountable for the original amount of funds borrowed. In a fair market value exchange, an issuer in severe financial distress seeks to reduce its overall debt obligations by exchanging an existing debt for a new debt with a reduced principal amount that is determined by the market value at which the old debt is trading.

The amount of interest creditors receive back when the debt in either exchange matures is OID. OID is defined by the Internal Revenue Code (the “Tax Code”) as the “excess (if any) of the stated redemption price at maturity over the issue price.” 26 U.S.C. § 1273. It further describes “stated redemption price at maturity” as “the amount fixed by the last modification of the purchase agreement and includes interest and other amounts payable at that time (other than any interest based on a fixed rate, and payable unconditionally at fixed periodic intervals of one year or less during the entire term of the debt instrument).” Id. Usually the interest in a debt-for-debt exchange is paid out all at once when the debt matures but, for tax or accounting purposes, the interest is accounted for as if it were paid out over the life of the debt. Thus, under the Tax Code, for purposes of determining taxable income, a debt-for-debt exchange generates new OID.

Because section 502(b)(2) of the Bankruptcy Code allows a bankruptcy claim except to the extent such a claim is for “unmatured interest,” it was unclear how unaccrued OID would be treated in the bankruptcy context. 11 U.S.C. § 502(b)(2). With respect to face value exchanges, the Second Circuit has held that “OID on the new debt consists only of the discount carried over from the old debt, that is, the unamortized OID remaining on the old debt at the time of the exchange.” LTV Corp. v. Valley Fid. Bank & Trust Co. (In re Chateaugay Corp.), 961 F.2d 378, 383 (2d Cir. 1992). As such, the In re Chateaugay court held that OID in a face value debt exchange was not unmatured interest and thus was an allowable claim in bankruptcy. The Second Circuit reasoned that its decision comports with the legislative intent of encouraging debtors to avoid bankruptcy by cooperating with creditors and, in doing so, took into account the “strong bankruptcy policy in favor of the speedy, inexpensive, negotiated resolution of disputes, that is an out-of-court or common law composition.” Id. at 382.

Left unanswered by the Second Circuit was whether the same logic applies to OID generated in a fair market value debt exchange, which was resolved in In re Residential Capital LLC.

In re Residential Capital LLC

On May 5, 2008, Residential Capital, LLC (“ResCap”) offered to exchange its prepetition debt of $6 billion in unsecured notes for about $4 billion in new junior secured notes, and $500 million in cash. Because the issue price of the junior secured notes was established based on the approximated market value of the old notes, this was considered a fair market value exchange. The official committee of unsecured creditors and ResCap sought a determination from the bankruptcy court that unaccrued OID in this fair market value debt exchange, totaling about $377 million, was not an allowable claim because it was “unmatured interest” under the Bankruptcy Code.

With the Chateaugay decision as guidance, the court determined that OID in a fair market value exchange was not disallowed by Section 502(b)(2). He determined from the testimony of both the plaintiffs’ and defendants’ experts at trial that there was no basis for distinguishing OID generated by fair value exchanges from OID generated by face value exchanges. Both “fair and face value exchanges offer companies the opportunity to restructure out-of-court, avoiding the time and costs – both direct and indirect – of a bankruptcy proceeding.” In re Residential Capital, LLC, 501 B.R. at 578-79.

The court noted that Section 502(b)(2) was passed at a time when debt-for-debt exchanges did not create OID for tax purposes. It was only after the 1990 amendments to the Tax Code that both distressed face value exchanges and fair value exchanges created taxable OID. He further noted that the both the Second Circuit and the Fifth Circuit[1] have found that, notwithstanding the Tax Code, face value exchanges do not create disallowable unmatured interest. “The tax treatment of debt-for-debt exchanges derives from the tax laws’ focus on realization events, and suggests that an exchange offer may represent a sensible time to tax the parties. The same reasoning simply does not apply in the bankruptcy context.” Id. at 587.

The court found that all the features that companies consider in connection with a debt-for-debt exchange can be used in either face value or fair value exchanges, including: granting of security in the issuer’s collateral; interest rate; maturity date; payment priorities; affiliate guarantees; other lending covenants; redemption features; adding or removing a sinking fund or conversion feature; and offering stock with the new debt. The court thus concluded that there is “no commercial or business reason, or valid theory of corporate finance, to justify treating claims generated by face value and fair value exchanges differently in bankruptcy” and he held that the junior secured noteholders claim was not reduced by the unaccrued OID. Id. at 588.

Practical Implications

Notably, the court placed greater weight on the fact that both types of debt exchanges offer distressed entities the opportunity to restructure out-of-court. Both sides experts acknowledged that if the creditors knew that a portion of the OID created in a fair market value exchange would be disallowed, distressed companies would need to provide better inducements for participation, and it would likely lead to more bankruptcy filings as opposed to out-of-court workouts. Such a result would frustrate the strong bankruptcy policy favoring speedy, inexpensive, negotiated resolution of disputes.

By finding that OID created in a fair market exchange is an allowable claim in bankruptcy, the ruling in In re Residential Capital LLC has reduced one uncertainty in the distressed debt market which should encourage highly-leveraged companies and their creditors to restructure distressed debt in an exchange regardless of whether it is a fair market or face value exchange.

On February 18, 2014, Argentina filed a petition asking the United States Supreme Court to review the Second Circuit’s decision affirming the District Court’s decision requiring Argentina to pay a group of holdout bondholders (called “vulture funds” by Argentina’s counsel) 100% of the monies owed to them. As we discussed here, here, and here, the lower courts’ decisions are part of the fallout of Argentina’s 2001 default on nearly $100 billion of sovereign debt and subsequent attempt at restructuring that debt.

In its petition, Argentina challenges two aspects of the lower courts’ decisions: (1) the courts’ treatment of Argentina under the Foreign Sovereign Immunities Act, and (2) the courts’ interpretation of the pari passu clause in the bonds.

Argentina characterizes the lower courts’ decisions as “deeply offensive to Argentina’s sovereignty” and argues that the decisions “flout the Foreign Sovereign Immunities Act…and have upended expectations in the sovereign debt markets.” Argentina argues that the decisions violate sovereign immunity because they “effectively reach into Argentina’s borders, coercing it into violating its sovereign debt policies and commandeering billions of dollars of core sovereign assets.” Argentina contends that these rulings “spark international tension.”

Argentina also argued that the interpretation of the pari passu clause in the bonds should be certified to the New York Court of Appeals because the bonds were issued under New York law. Pointing to purported flaws in the lower courts’ interpretation of the clause, Argentina asserted that “[i]f New York courts want New York law to upset settled expectations, impede restructurings, and endanger New York’s status as the law of choice for sovereign debt, that is their prerogative. But they should not have those consequences thrust upon them.”

As discussed here, the Supreme Court previously agreed to hear an appeal of a related Second Circuit decision allowing holdout bondholders to subpoena banks for information about Argentina’s assets. That argument will take place on April 21, 2014. If the Supreme Court agrees to hear this latest appeal, argument would be scheduled during the next term, which begins in October.

On November 18, 2013, the Second Circuit issued an order denying Argentina’s petition for rehearing of the court’s decision upholding an injunction that barred Argentina from paying holders of restructured debts while “holdout” creditors remain unpaid. NML Capital, Ltd. v. Republic of Arg., Case No. 12-105, Docket No. 1035 (2d Cir. Nov. 18, 2013). As discussed here and here, the “holdout” creditors are primarily hedge funds who declined Argentina’s 2005 and 2010 restructuring offer to trade sovereign bonds for newly issue bonds at a significant haircut and are now trying to collect on the original debt.

The district court injunction remains stayed pending further appeals. Argentina has 90 days to petition the Supreme Court to review the case. As discussed here, the Supreme Court rejected Argentina’s earlier petition to hear the interim decision of the Second Circuit that all bondholders must be treated equally.

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Hughes Hubbard’s Corporate Reorganization & Bankruptcy group represents companies, creditors and trustees in complex restructurings—both in and out of court—and in the multiple types of litigation that insolvency proceedings generate.

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